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TAX NEWS - FEBRuary 2010

Top 12 Tax Scams - California Tax

It's a new year and a good time to remind your clients about the top tax scams. Our publication, FTB 987, Franchise Tax Board Top Twelve Tax Scams, will help you assist your clients how to identify and avoid the most common scams, from tax shelters to abuse of charitable organizations and deductions.

We urge California taxpayers to avoid the common scams detailed in this publication. The publication also provides information on how to report suspected tax fraud. For our online application, go to ftb.ca.gov and search for tax fraud. To learn more about the top 12 tax scams, go to ftb.ca.gov and search for FTB 987.


Top 12 Tax Scams

The primary focus of the Franchise Tax Board (FTB) is to collect the proper amount of tax revenue, and operate other programs entrusted to us, at the least cost. Creating a tax system where every taxpayer pays the correct amount of tax — no more and no less — goes to the heart of our mission to fairly and effectively administer the State's income taxes. Promoters of fraudulent tax scams attempt to cheat our tax system, which is a contributing factor to California's increasing tax gap. The tax gap is defined as "the difference between what taxpayers owe and what they pay voluntarily." Currently, the FTB estimates the State's annual income tax gap is $6.5 billion.

The FTB is dedicated to continuing existing efforts to counter fraudulent activity through audit enforcement, partnering with the Internal Revenue Service (IRS), and educating the public. This brochure is designed to assist taxpayers in identifying and avoiding the twelve most common tax scams affecting California taxpayers. The FTB urges California taxpayers to avoid the common schemes detailed in this publication. Several of the tax scams popular in California appear on the 2007 IRS "Dirty Dozen" tax scams list (starting with item 7). For additional information on federal tax scams, please visit the IRS Website.


1. Tax Shelters

The FTB is actively pursuing abusive tax avoidance transactions (tax shelters), which continue to be a problem. By partnering with the IRS and other states, the FTB avoids duplicating audit activity and optimizes the number of taxpayers examined. Estimates show California loses $600 million to $1 billion in tax revenue annually through abusive tax shelters. Abusive tax shelters are "transactions marketed with the promise of tax benefits with no correlating risk of economic losses." As the old saying goes, "If it sounds too good to be true, it probably is." These transactions typically have no economic purpose other than reducing taxes. The FTB continues to vigorously pursue abusive tax shelter participants and their promoters by assessing increased penalties as provided by California law.


2. Tax Credits and Tax Incentives

Some tax preparers recommend taxpayers claim tax credits such as the enterprise zone credit, research and development credit, and other associated tax credits for which the taxpayer does not qualify. This is fraud. The FTB Audit Division is continuing their examinations of these credits and incentives to verify the credits have been properly claimed.


3. Phony Home-Based Business

Some promoters market a package, kit, or other materials that claim to show taxpayers how they can avoid paying income taxes. This tax scam purports to legitimately offer tax relief, however, it is illegal tax avoidance. The promoters of this scheme claim that individual taxpayers can deduct most, or all, of their personal expenses as business expenses by setting up a bogus home-based business. The Internal Revenue Code provides that a clear business purpose and profit motive must exist in order to generate and claim allowable business expenses. Personal, family, and living expenses are not deductible business expenses. Creating the appearance of having a home-based business, where none actually exists, and deducting personal, living, or family expenses is in violation of the tax laws. This scam has been around for many years, and both the IRS and FTB continue to see activity in this area.


4. Internet Businesses

Many online promoters claim to offer legitimate ways to reduce a taxpayer's income taxes, or even to pay no taxes at all. Many promoters market bogus websites, home-based businesses, and incorporation packages on the Internet that purport to entitle the taxpayer to big write-offs. After paying large fees to the promoter, taxpayers are erroneously told by the promoter that they may claim business deductions and write-offs because they have the appearance of a business. A business must truly exist prior to claiming expenses. Expenses must be "ordinary and necessary" in relation to a legitimate business activity, and satisfy all other requirements in order to be deductible business expenses on a tax return. This scheme is a variation of the Phony Home-Based Business, described in item 3.


5. Offshore Accounts

Another popular scam involves the use of offshore accounts. Promoters offer their services with the stated intent to hide unreported income from the government. Bank secrecy laws in approximately 30 countries, which operate as tax havens, have made it easier to conceal income and evade taxes. One of the most popular methods to access offshore funds in recent years is the use of bankcards (i.e., credit/debit cards). The IRS has acknowledged bankcards linked to offshore accounts are not necessarily illegal, as long as the accounts are reported. The FTB continues to actively audit suspected unreported offshore accounts and income.


6. Moving a Business Out of State

Some promoters advocate incorporation of a business in a non-income taxing state to avoid paying California income taxes. California residents, however, are taxed on all income, including income from sources outside of California. If a California resident incorporates his or her business outside of California but remains a California resident, any dividends or salary received by the individual from the corporation will be taxable in California, regardless of where the corporation is incorporated or does business. In addition, non-California residents who receive income that is sourced to California may be required to pay California tax, regardless of where that corporation is incorporated or does business. Any corporation doing business in California, regardless of where it is incorporated, is subject to California franchise tax.


7. Phishing

Phishing is a technique used by identity thieves to acquire personal financial data in order to gain access to the financial accounts of unsuspecting consumers, run up charges on their credit cards, or apply for loans in their names. These Internet based criminals pose as representatives of a financial institution -- or sometimes the IRS itself -- and send out fictitious email correspondence in an attempt to trick consumers into disclosing private information. A typical email notifies a taxpayer of an outstanding refund and urges the taxpayer to click on a hyperlink and visit an official-looking Website. The Website then solicits a social security and credit card number. Another variation of this type of email notifies the recipient he or she is under criminal investigation by the IRS for submitting a false tax return to the FTB or a complaint has been lodged against the recipient. There are many variations of these phishing emails. It is important to note the FTB does not use email to initiate contact with taxpayers about issues related to their accounts. If a taxpayer has any doubt whether a contact from the FTB is authentic, the taxpayer should call the FTB at (800) 852-5711 to confirm it.


8. Disguised Corporate Ownership

Domestic shell corporations and other entities are being formed and operated in certain states for the purpose of disguising the ownership of the business or financial activity. Once formed, these anonymous entities can be, and are being, used to facilitate underreporting of income, non-filing of tax returns, listed transactions, money laundering, financial crimes, and possibly terrorist financing. The IRS and the FTB are working together to identify these entities and bring their owners into compliance.


9. Return Preparer Fraud

Dishonest tax return preparers can cause many headaches for taxpayers who fall victim to their schemes. Such tax preparers make their money by skimming a portion of their clients' refunds and charging inflated fees for return preparation services. They attract new clients by promising large refunds. Taxpayers should choose carefully when hiring a tax preparer. Remember that no matter who prepares the return, the taxpayer is ultimately responsible for its accuracy. Since 2002, the courts have issued injunctions ordering dozens of individuals to cease preparing returns, and the Department of Justice has filed complaints against dozens of others. During fiscal year 2006, 109 tax return preparers were convicted of federal tax crimes and sentenced to an average of 18 months in prison.


10. Trust Misuse

For years, promoters have urged taxpayers to transfer assets into trusts. They promise reduction of income subject to tax, deductions for personal expenses, and reduced estate or gift taxes. However, some trusts do not deliver the promised tax benefits. Abusive trust arrangements often use trusts to hide the true ownership of assets and income or to disguise the substance of transactions. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, as would be the case with legitimate trusts, the taxpayer in fact controls them. Trusts established to hide the true ownership of assets and income or to disguise the substance of financial transactions are considered fraudulent trusts. The IRS has more than 150 active abusive trust investigations underway and 49 injunctions have been obtained against promoters since 2001. The FTB is actively examining these types of trust arrangements. As with other arrangements, taxpayers should seek the advice of a trusted professional before entering into a trust.


11. Abusive Roth IRAs

Taxpayers should be wary of advisers who encourage them to shift under-valued property to Roth Individual Retirement Arrangements (IRA). Disguised contributions to a Roth IRA artificially shift taxable income away from the taxpayer into the shelter of the Roth IRA structure. Contributions to an IRA through a transaction that disguises the value of the contribution may disqualify the IRA. In one variation, a promoter has the taxpayer move under-valued common stock into a Roth IRA, circumventing the annual maximum contribution limit and allowing otherwise taxable income to go untaxed.


12. Abuse of Charitable Organizations and Deductions

The IRS and FTB continue to observe the use of tax-exempt organizations to improperly shield income or assets from taxation. This can occur when a taxpayer moves assets or income to a tax-exempt supporting organization or donor advised fund but maintains control over the assets or income. Contributions of non-cash assets continue to be an area of abuse, especially with regard to overvaluation of contributed property. In addition, the IRS is noticing the return of private tuition payments being disguised as charitable contributions to religious organizations.


How to report suspected Tax Fraud activity?

If you suspect that an individual or company is not complying with California income tax laws, you can report that information tothe FTB.

By Phone: (800) 540-3453

By Mail: Franchise Tax Board
PO Box 1565
Rancho Cordova CA 95741

By Fax: (916) 843-2060

Please note that you are not required to provide the Franchise Tax Board with any identifying information. However, if you choose to provide us with your personal information, we will treat that information as confidential unless compelled by law.


Please include the following details if available:
- Individual/business name.
- Marital status.
- Spouse's name.
- Individual/business address.
- Alleged tax violation.
- How you became aware of the alleged violation.
- Availability of supporting documents.
- Asset information (vehicles, property, etc.).
- Have you provided this information to the Internal Revenue Service (IRS) or other state agency? If yes, please provide the agency/department name and contact person.
- Do you have reason to believe the taxpayer is dangerous?
- Your contact information.
- Your relationship to taxpayer.
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